An extremist, not a fanatic

September 25, 2009

Investment, growth & animal spirits

Duncan says we should be concerned by today’s news of a collapse in capital spending because “investment is the driver of long term growth.”This sounds sensible. But it raises a problem, shown by my chart. It plots the share of business investment in GDP, measured in current prices, against annualized GDP growth over the following five years.

There’s a negative relationship between the two. High investment leads to slow growth, and low investment to high growth. This relationship suggests that today’s figures - showing the investment-GDP ratio at its lowest since records began in the mid-60s - are a reason for optimism about economic growth, not pessimism.There might be a simple reason for this. Businesses’ investment decisions are not rational. High capital spending, then, is not a sign that there are lots of growth opportunities in the economy, but that bosses are irrationally overconfident and have been swept away by the euphoria of an economic boom - a fact magnified by the fact that capital spending is excessively sensitive to current profits; firms invest because they have the cash to do so. And booms lead to busts. Similarly, low spending is an indicator not that growth opportunities are scarce but simply that animalspirits and current profitability are irrationally depressed.If this is right, today’s low investment tells us not that the economy is heading for hard times, but simply that bosses are irrational.There are, however, (at least) two counter-arguments here.1. This time is different. Current low investment isn’t due to irrational pessimism, but to firms being starved of finance by banks. 2. In looking at actual GDP growth, I’m using the wrong metric. Maybe capital spending does influence trend GDP growth, the rate at which the economy can grow without generating inflation.I’m not sure, though, if any of this actually rejects Duncan’s main point. After all, if investment is so swayed by irrational animal spirits then there might - subject to other postulates - be a case for taking it out of capitalists’ hands, as Keynes said.

I was talking about trend growth - should have been clearer. I think Dale Jorgenson's stuff on this is very interesting.

"Exploiting the new data and methodology, I have been able to show that
investment in tangible assets is the most important source of economic growth in
the G7 nations. The contribution of capital input exceeds that of total factor
productivity for all countries for all periods. The relative importance of total
factor productivity growth is far less than suggested by the traditional
methodology of Kuznets (1971) and Solow (1970), which is now obsolete."

I think the chart above is essentially picking up the accelerator effect, no? Investment lags consumption and is more variable, so it will tend to rise as a share of GDP towards the end of the cycle as growth slows. So high investment/GDP is indeed followed by low GDP growth, but the causation is the other way round.

I suspect the current low level of investment probably mainly reflects the massive fall in overall output since Q3 last year, together with some of the capital-starving effect from the knackered financial system, suggesting it will pick up as (or a little while after) consumption does.

I always had a hunch this graph would show a reverse slope. Partly that arises from noting how silly a lot of businees investment is (see GM). The other half of my hunch is a matter of accounting. If business is booming, you write off as much as possible as current spending. If things are slow, you write as much as possible to investment. Didn't expect as steep a slope though.

My guess still is that government investment against economic growth would show an even steeper reverse slope.

Curious,
but I wonder why you wouldn't expect diminishing returns over time as capital is accumulated.
I thought that maybe there are other mechanisms involved here. Imagine there are increasing returns to scale and monopolistic competition, where market share is highly uncertain. Couldn't be that a growing market, means a fight for market share and as a result increasing excess capacity? i.e. Much more "unnecessary" investment (unnecessary from the point of view of efficiency, but maybe useful if competition is a good thing).